'Fiscal Nightmare' Not Based in Reality

Paul Wallace|Special to CNBC.com

Friday, 16 Mar 2012 | 11:34 AM ET

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Paul Wallace is the European economics editor of The Economist.

The state of the state by 2050? Bust is the received wisdom: bankrupted by the burden of the old. Public finances already overloaded by higher debt in the wake of the banking crisis and great recession of 2008-09 will collapse as population ageing makes the weight of state-funded pensions and health care too heavy to bear. The failed states of 2050 won’t be Afghanistan or Somalia but rather the US or France.

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This fiscal fatalism will prove to be wrong. Instead of going bust the state of 2050 will be fitter and smarter than it is today. Fitter because governments will shed onerous pension and health commitments. And smarter because they will foster the economic growth essential for sound public finances by investing in education and innovation.

The fiscal projections enshrouding the state of the future in so much gloom are based on crude demographic determinism. As populations age, raising the ratio of the old and retired to the young and employed, public spending on the two big programmes of pensions (Social Security in America) and health care will become unaffordable.

But there is nothing ineluctable about the public bills of ageing. If retirement ages set when life expectancy was much lower were immutable the bills for pensions would indeed soar. But 65, the historic norm, is no longer sacrosanct. State-pension ages are going up across the developed world and will increasingly be linked to life expectancy so that they rise automatically as people live longer. And there are other ways of containing costs, notably by restricting the public role to providing a minimum retirement income.

Even if the state can constrain pensions, won’t it nonetheless buckle under the strain of greater health-care spending as people live longer? This fear is widespread because medical bills for the old are much higher than those for the young. But that is largely because a big chunk of lifetime medical spending is incurred a year or so before death, whatever one’s age, and most deaths now are among the old. Rising longevity reflects improved health and postpones the peak years of spending rather than lengthening them.

Public spending on health has already lurched out of control owing to expensive new technologies and malfunctioning medical markets. These are the crucial cost pressures that must be capped. Three reforms will be crucial. One is to get individuals to contribute more themselves through private insurance (while protecting the poor and those with chronic diseases). The second is to enhance competition and so reduce the power of the medical providers who currently call the shots. The third is to deploy a technology that lowers rather than raises costs. Information technology offers tremendous scope to boost efficiency in health care not least since doctors and hospitals have been so woefully backward in adopting it.

As states curb their commitments to the old they will step up their investment in the young. Public finances will stay sound only if economic growth remains healthy and that will require better skills. As young people become scarcer, it will be even more vital to ensure that they start work as highly qualified as possible, which will require more rather than less spending on education both in schools and universities and during their working lifetimes.

The state of 2050 will also do much more to encourage innovation. Whereas developing economies can grow fast simply by investing heavily and catching up with best practice, advanced countries must push out the technological frontier. The state can help by financing pure science and supporting R&D and high-tech start-ups.

The politics of reshaping the state will undoubtedly be tough. Retiring later and contributing more to private health insurance will be unpopular. Won’t the old, who will make up a larger share of the electorate, block reforms? This despairing claim is often made, yet no one, young or old, has an interest in a bust state. That is why the fiscal nightmare that lies ahead will remain just that. The reality in 2050 will be a fitter, smarter and solvent state.